Carbon Pricing in Canada

As we enter 2017, the governments of Canada and several provinces are poised to implement significant new measures to mitigate climate change.

At the forefront of these initiatives are efforts to establish an escalating price on greenhouse gas emissions. For example, on January 1, 2017, Ontario’s new cap-and-trade program came into effect, covering the emissions of around 85% of the province’s economy. Alberta also recently announced a carbon levy that, along with new performance standards for large industrial emitters, will cover between 78-90% of Alberta’s emissions. Meanwhile, after months of negotiation, the federal government, eight provinces and three territories signed the Pan-Canadian Framework on Clean Growth and Climate Change Framework on December 9, 2016. An essential feature of the Framework is a federal benchmark for provincial and territorial efforts to price carbon emissions.

These federal and provincial programs are expected to increase the price of fossil-based energy in Canada. In particular, the costs of three major energy types will likely be impacted: electricity, natural gas, and petroleum-based fuels. As these initiatives move ahead in Canada, what will the impact of a carbon price on the cost of energy be in a carbon constrained environment?

1. Ontario’s Cap-and-Trade Program

Ontario’s cap-and-trade program limits the greenhouse gas emissions of major emitters in the province. Under the program, those emitters must cover their emissions in each compliance period with an equivalent amount of emissions credits. These credits—called either emissions allowances or offset credits—can be procured in auctions, the secondary market or reserve sales, and can be traded among emitters and other market participants. Some emitters will also receive free allowances from the province. The first compliance period in Ontario’s program began on January 1, 2017 and will run until the end of 2020, followed by successive three-year compliance periods.

Emitters Covered by the Program

Large industrial emitters with 25,000 tonnes or more of carbon dioxide equivalent (CO2e) emissions per year;

Natural gas distributors with attributed emissions of 25,000 tonnes or more of CO2e per year;

Petroleum product suppliers that supply 200 litres or more of petroleum products in the province per year; and

Importers of more than zero megawatt hours of electricity into the province per year.

Approximately 150 large industrial emitters and several more natural gas distributors, petroleum product suppliers and electricity importers will be registered under the cap-and-trade program.

The price of carbon in the Ontario cap-and-trade program reflects the costs of emissions allowances sold at auction and in the secondary market. In 2017, Ontario will release into the system, whether through auction or free allocation, an amount of allowances roughly equal to the expected emissions for that year, which is meant as a “soft start” to compliance obligations. The cap would then decline between approximately 4-5% each year during the first compliance period, reducing the number of allowances available, thereby incentivizing emissions reductions.

Ontario intends to link its cap-and-trade market with that of California and Québec as early as 2018. Market linkage will result in the three markets holding joint auctions of emissions allowances. It will also allow emitters in Ontario to purchase credits on the secondary market from covered emitters in these other markets and vice versa. This in turn will equalize the effective carbon price (i.e., the price of allowances) in these jurisdictions.

California and Québec already have linked cap-and-trade systems. Those jurisdictions established their own systems in 2013, and linked them together in 2014. Since then, California and Québec have held joint quarterly auctions where allowances are sold subject to a uniform floor price. Due to an oversupply, allowances have tended to sell at or slightly above the floor price in these joint auctions, most recently at C$17.29 per tonne in the November 2016 auction. The floor price increases by 5% per year plus inflation. The Ontario government will also hold four auctions per year (and intends to participate in joint auctions upon being linked) and will adopt the California-Québec floor price to align with those jurisdictions.

Ontario’s cap-and-trade program will not only create cost implications for capped participants, but also impact the cost of energy consumption across the province.

As mentioned above, certain large industrial emitters will be allocated free emission allowances during the first compliance period. This is intended to provide transition assistance and minimize carbon leakage (i.e., the shift of production to another jurisdiction with less stringent carbon pricing policy). However, natural gas distributors, petroleum product suppliers and electricity importers are among the entities that do not qualify for free allocation of allowances. They are thus responsible for procuring allowances and credits to cover their emissions. As discussed further below, the resulting compliance costs are expected to trickle down to energy consumers who are not covered emitters, but who purchase fossil-based energy such as natural gas and petroleum fuels. Therefore, the cap-and-trade program will not only create cost implications for capped participants, but also impact the cost of energy consumption across the province.

2. Pan-Canadian Framework on Clean Growth and Climate Change

While provinces like Ontario, Québec, B.C. and Alberta have established plans to price carbon either directly (through a carbon tax like that in B.C.) or a cap-and-trade system (like those in Ontario and Québec), the federal government has also sought to establish a uniform price of carbon across the country. In part, this effort is designed to ameliorate concerns that carbon-intensive industries that compete inter-provincially would be advantaged in those jurisdictions without a carbon price, possibly leading to the leakage of certain industry (and associated emissions) to those jurisdictions without a carbon price.

After over a year of negotiations with the provinces, the Government of Canada announced the Pan-Canadian Framework on Clean Growth and Climate Change (the Framework) on December 9, 2016. The agreement, which was signed on to by eight provinces and three territories, outlines a federal benchmark for carbon pricing. The essential feature of the Framework is the federal benchmark for pricing greenhouse gas emissions. To meet the benchmark, jurisdictions can implement either: (i) an explicit price-based system (e.g., British Columbia’s carbon tax or Alberta’s carbon levy tied to a performance-based emissions system); or (ii) a cap-and-trade system (e.g., Ontario and Québec’s cap-and-trade programs). The benchmark will apply to substantively the same sources as British Columbia’s carbon tax, and will become more stringent over time to support Canada’s 2030 emissions reduction target of 30% below 2005 levels.

For price-based systems, the benchmark carbon price would start at a minimum of $10 per tonne in 2018, rising by $10 per year to $50 per tonne in 2022. In contrast, jurisdictions that adopt cap-and-trade are expected to achieve: (i) emissions reductions of at least 30% below 2005 levels by 2030; and (ii) declining annual caps to at least 2022 that correspond, at a minimum, to the projected emissions reductions resulting from the carbon price that year in price-based systems. As a backstop, the federal government plans to introduce a price-based system in jurisdictions that do not meet the benchmark. Therefore, not only can the Framework impact the carbon price in provinces that have already implemented a carbon tax or cap-and-trade program, it can also establish a carbon price in provinces that have not done so.

3. Impacts on Energy Costs

Given the Framework, the carbon price in any given province will effectively be determined by the provincial carbon price, supplemented if necessary by the Government of Canada’s backstop carbon price. In combination, federal and provincial initiatives will increasingly impact the cost of fossil-based energy across the country. The example of Ontario shows how these carbon prices translate into higher costs for electricity (assuming fossil-based generation in the supply mix), natural gas and petroleum fuels.

a. Impact on Electricity Costs

Under Ontario’s program, the emissions from electricity generators will be capped upstream at the point of fuel distribution, with some exceptions. Currently, the vast majority of GHG emissions from Ontario’s electricity sector result from the combustion of natural gas in generating facilities. Under cap-and-trade, natural gas distributors will be required to, among other things, procure allowances to cover the emissions associated with the fuel they supply to these generators. An exception to this rule is where generation facilities are supplied directly from an inter-provincial or international gas pipeline. In most of such cases, the gas-fired generators must register as mandatory participants in the cap-and-trade program.

The added price of carbon will increase the variable operating costs of gas generators. The increase in operating cost is expected, in certain circumstances, to lead to higher offers into the wholesale electricity market. When gas is on the margin (i.e., sets the market clearing price), higher offer prices of gas generation output would drive up the Hourly Ontario Energy Price (HOEP).

In combination, federal and provincial initiatives will increasingly impact the cost of fossil-based energy across the country.

The cost implications for large industrial consumers are driven not only by the commodity price of electricity but also to a major extent by the Global Adjustment, which generally speaking represents the difference between the HOEP and the cost required to cover certain long-term generation contracts. In effect, an increase in the HOEP will lead to decreased Global Adjustment. Since Class A consumers (generally, large consumers with average demand of 5MW or more) are currently assessed Global Adjustment charges based on their contribution to the provincial demand peaks, they have the opportunity to reduce these charges by lowering consumption during peak hours. Therefore, assuming this allocation methodology remains unchanged, lower Global Adjustment means fewer savings opportunities are available to Class A consumers from load shifting efforts. This effect may be accentuated if gas fired generation takes on an increasingly important role as part of Ontario’s supply mix during the planned refurbishment and shutdown of certain nuclear generating units.

b. Impact on Natural Gas Costs

Starting in 2017, gas distributors will face the following types of cap-and-trade related costs, which will ultimately be passed on to gas consumers:

Costs for customer-related obligations. Gas distributors will procure allowances to cover GHG emissions associated with the natural gas they deliver to customers who are not already covered emitters, including most gas-fired generators.

Costs for facility-related obligations. Gas distributors must also procure allowances to cover GHG emissions stemming from their owned or operated facilities.

Administrative costs to discharge the above obligations.

In preparation for the commencement of the cap-and-trade program, the Ontario Energy Board (OEB) has through consultation developed a regulatory framework for assessing the costs of gas distributors’ cap-and-trade activities. The OEB has determined that: (1) customer-related costs will be recovered on a volumetric basis from all customers except those responsible for managing their own compliance obligations; (2) facility-related costs will be recovered on a volumetric basis from all customers; and (3) administrative costs will be allocated to all customers in the same manner as existing administrative costs.

According to filings made with the OEB, assuming a 2017 carbon price in Ontario of $17.70/tonne, the typical residential customer consuming natural gas could expect a bill impact of approximately $75 per year. For large industrial natural gas users, this number is significantly higher. Assuming a large facility consumes 20 million m3 of natural gas per year, the carbon price in 2017 could result in increased gas costs of over $500,000 per year, with that amount escalating with any increase in the price of allowances.

c. Impact on Costs of Petroleum Products

A person that supplies 200 litres or more of petroleum products in the province per year will be covered under the cap-and-trade program. Capped suppliers will include owners or operators of petroleum refineries or fractionation facilities as well as importers of petroleum product into Ontario. The added price of carbon will likely be passed down to end users of petroleum products, which include automotive gasoline, diesels, light and heavy fuel oils, petroleum coke and propane.

Although the full impact of carbon pricing on petroleum products remains to be seen in Ontario, the Province has indicated that gasoline price will likely rise by 4.3 cents per litre (cpl). This appears to be in line with the experience in Québec, where for instance, certain petroleum product suppliers charge the following per-unit amounts (effective as of September 1, 2016) to cover the cost of procuring emissions allowances under that province’s cap-and-trade program: (1) 3.50 cpl on E10 gasoline; (2) 3.88 cpl on conventional gasoline; (3) 4.95 cpl on diesel; and (4) 4.50 cpl on furnace oil.

Conclusion

The combined effects of federal and provincial programs to price greenhouse gas emissions are likely to reach well beyond the price of fossil-based energy, and it will be interesting to watch how these effects manifest as companies in Canada enter this new era of carbon pricing in the year ahead.